Did the End of the Investment Banks Cause the Latest Sell-Off?

Robert Peston thinks that much of the recent sell-off can be attributed to the decision by Goldman Sachs and Morgan Stanley to convert into banks:

It was caused, to a large extent, by an exceptional and unprecedented shrinkage in the prime brokerage industry, which in turn led to a serious reduction in the volume of credit extended to hedge funds, which in turn forced hedge funds to sell assets, especially those perceived as higher risk...

Morgan Stanley and Goldman are - by far - the biggest prime brokers, with Morgan Stanley the number one.

But as banks, they're prevented by regulators from lending as much relative to their capital resources as they had been as securities firms.

So the US authorities should have known - and presumably did know - that by allowing Morgan Stanley and Goldman to become banks they were in effect forcing a serious contraction in the hedge-fund industry, which in turn would lead to sales of all manner of assets held by hedge funds and precipitate turmoil throughout the financial economy.

I'd love to see some datapoints here. Is it true that the prime-brokerage operations of Goldman Sachs (GS) and Morgan Stanley (MS) have been shrinking, even as competitors such as Lehman Brothers and Bear Stearns have gone bust? It might be the case that the total amount they've lent out to hedge funds has declined, even if their client count is rising. And I'm sure that there's been a lot of pressure both internally and externally for those shops to derisk and deleverage.

But the fact is that as soon as the investment banks started getting access to the Fed's money, they were bound to become much more tightly regulated -- whether they became banks or not. Has that process been sped up by their move to become banks? Frankly, I doubt it -- no one at Treasury or at the SEC is interested in giving Morgan Stanley (MS) and Goldman Sachs (GS) a hard time right now over the fact that they don't immediately conform to all the requirements of banks. These things take a certain amount of time, and everybody understands that.

But are hedge funds being forced to sell assets because their prime brokers are derisking? That's entirely possible. But I'd be more convinced if I was shown an actual instance of it happening.

Comments

[Alex Filonov:]

Interesting. Even more interesting if it's true and if we can find out how much more money MS and GS are going to withdraw from hedge funds. Might just give some feel of where the bottom is. Right now hedge funds are the stock market.

2008 Oct 27 05:42 PM

[raising4dau...:]

The end of investment banks did not cause the sell-off. Half of the 40% decline is attributed to normal bear-market activity in the face of a recession. The other half is attributable to an insurmountable lead by a pronounced Marxist with ultra-leftists running both houses of Congress.

The Dow would still be in the 10,000 - 11,000 range if McCain was in the lead.

Fact.

2008 Oct 27 08:28 PM

[lcs:]

It has already become conventional wisdom that the selloff is due to forced liquidations by hedge funds. But I've seen no consensus as to whether it is driven from redemptions or bank margin calls.

2008 Oct 27 08:30 PM

[letsmakemoney:]

Hedge funds that use leverage (not all do, i.e., distressed HFs) are de-leveraging because they have no choice: not only are redemptions streaming in ahead of 12/31 exit points, all prime brokers are scaling back the amount of financing they can/will provide in the new investment bank regime that is unfolding.

This has impacted a number of markets, but what has become particularly interesting due to this massive de-leveraging are convertible bonds. Do your own research (type the word convertible in the Yahoo quote box), there are closed end funds and mutual funds out there that currently yield 10-20%, due, in my opinion, to convertible bond arbitrage (CBA) players being forced out of the game, in wholesale fashion.

CBA is (was) a heavily leveraged strategy (5-10x), reliant upon prime broker provided leverage. CBA happens to be the worst hedge fund strategy on the basis of performance YTD (HFR data), with both Sep and Oct being record disastrous months. Some funds are down 50%+ in just these 2 months alone. Citadel has been in the press refuting solvency rumors, likely relating to their convert exposure. They probably started buying a little too early in the selloff is my guess.

I do not believe these terrible CBA HF returns are a coincidence, and they have been greatly exacerbated by the changes taking place in the prime brokerage industry. There is no where else to obtain financing. The only bids out there for converts are long-only, non-leveraged participants, and they simply don't have the cash to absorb the sudden avalanche of forced convertible bond selling (as the arbs unwind, they sell the bonds and buy the stock back).

Buying converts seems like one of the more compelling risk-adjusted trades out there at the moment. They appear to be offering equity like returns, with bond like risk. Yes, they are subject to the economic troubles we are facing, and default risk is real, but equities are even riskier as they can go to zero. Why would a risk-averse investor buy stocks until this other market opportunity goes away? Downside protection is provided by the bond floor inherent in the convert, and they participate in upside market rallies due to the embedded call option they contain (they can be converted into stock, although the delta on them is now very low). The big risk seems to be further de-leveraging, so approach with caution and size your position accordingly.

Barron's finally picked up on this on Sunday, and has a full article on converts, but they barely scratched the surface on what's really going on.

online.barrons.com/art...

2008 Oct 27 10:36 PM

[User 71492:]

I am puzzled by the stock market in the US. It is the most levered economy in the world and yet there are no fear in the market. Everyone is calling this a bottom. The DOW is only down less than 40% with no visibility of the depth of the recession, the bottom of housing, job market, etc..... yet most US market participants feels that US equities are cheap and the reason they are going down is caused by hedge fund.

During the past decade, Americans have lost the sense of fear, right or wrong, honor, shame, etc.... what is left is a sense of optimism which is based on ignorant.

2008 Oct 27 11:17 PM

[ANTS:]

RE: the comments above.

Given the huge amount of damage to people's retirement savings, plus the loss of confidence, should we not expect an authority to ask, "are you Prime Broker, reducing your exposure to your hedge fund clients, causing them to sell equities in a disorderly market, and by how much". And should we not expect an answer "Yes sir, by $XXX Billion".

Why on earth is the explanation of this event being left to conjecture?

2008 Oct 27 11:19 PM

[PainfullyAware:]

User 71492

The party is almost over - the hangover is about to begin.

All Empires End The Same Way.

Unfortunately, this time there is a lot of Nukes available.

I would hope that more rational heads prevail. Alas we now live in a Corprotocracy where money buys influence and the citizen is an impediment to profit.

2009-2010 is going to be a wild ride for everyone.

2008 Oct 28 02:37 PM

[kaps:]

Good observation Felix!

If we dig deeper into this, we will find the reason for not just US but global sell-off.

2008 Oct 29 07:31 AM